How Closed-End Funds Use Leverage to Boost Returns

Closed-end fund (CEF) managers can bulk up on debt to double down on various investment positions, a key characteristic of this complex and not always well understood corner of the investment world, experts say.

This ability to use leverage is one of the things that set closed-end funds apart from their far better known and more numerous siblings, open-end mutual funds and ETFs, that dominate today's markets, experts noted in a recent panel discussion on closed-end funds hosted by TheStreet.

Leverage, of course, is not the only tool in the $300 billion-plus closed-end mutual fund world.

Closed-end funds raise money to buy assets through the IPO process. A fixed number of shares are sold and then the fund is traded on various exchanges throughout the day.

Unlike standard open-end mutual funds which can expand or contract the number of shares based on market demand, the only way to sell shares in a closed-end fund is to find a buyer for them.

However, closed-end investors need to keep an especially close eye on what fund managers use their borrowing powers for, and how much debt they take on, noted TheStreet's panel of experts.

The ability to borrow, while a powerful tool for boosting returns, can be a double-edged sword, notes Daniel Silver, Portfolio Manager for Zoso Capital.

"It needs to be understood that leverage, it magnifies gains and losses," Silver said. "That's a B school 101 concept. That's very important to understand what you're talking about closed-end funds."

Closed-end funds that focus on bonds and other fixed-income investments not only make up the majority sector, but they are also known for their use of leverage, experts say.

About two-thirds of closed-end funds use leverage, notes Bill Meyers, a vice president at Nuveen, which offers several closed-end funds.

(Full disclosure: Nuveen is an advertiser on TheStreet, but did not participate in the preparation of this article.)

Closed-end funds can wield leverage in two ways. They can issue preferred shares, or they can borrow from a financial institution.

For investors weighing whether to buy shares of a closed-end fund, the prospectus may spell out its policy regarding debt and whether there is a cap on the percentage, Nuveen's Meyers noted. For example, if a closed-end fund raises $75 million through an IPO and then later issues $25 million in preferred shares, it is considered to be 25 percent leveraged.

But even if the fund doesn't spell out what its debt limits are, the total it can borrow is limited by a federal New Deal-era regulation inked back in 1940.

The Investment Company Act of 1940 caps leverage at 33% if it's borrowing and 50% if it's debt taken on by issuing preferred shares, Meyers said.

The amount of leverage taken on by closed-end bond funds is particularly noteworthy given the rising interest rate environment, experts on the panel noted.

Closed-end bond funds are particularly vulnerable to rising rates because they often borrow at short-term rates to buy higher paying long-term bonds. As short-term rates rise, the spread narrows between what the funds borrowed and what they paid for those long-term municipal bonds.

That reduces the amount of money closed-end bond funds have available to pay out to investors, which, in turn, could lead some funds to cut distributions. And debt ratios are higher for bond funds, and muni bond funds in particular, rising to 35 to 40 percent compared to 25 percent for closed-end funds that focus on equities, said John Cole Scott, chief investment officer of Closed-End Fund Advisors.

The Fed is expected to raise rates by a quarter-point this month, to 2.25%, followed by another bump in December, with more increases to follow in 2019. Strong economic growth and to some extent, rising inflation, are behind the Fed's moves, analysts have said.

"Generally speaking, if the funds are borrowing at shorter term rates, those rates moving higher over time, that will lead to lower distributions or distribution cuts," Meyers said.

Leverage can also accelerate losses if a downturn hits and it gets tougher to borrow. Examples where leverage turned against fund managers can be found during the "energy crisis" of 2015 and 2016 and the financial crisis of a decade ago,

"It does magnify the negative component as well as the upside component," Scott said.

Want to Buy $1 Worth of Stock for 90 Cents or Less? You can with certain so-called "closed-end" mutual funds -- an often overlooked investment class. Click here to register for a free online video in which TheStreet's retirement expert Robert Powell and an all-star panel tell you all you need to know.